Understanding, determining and applying EBITDA plays an important role in uncovering the value of your business and maximizing your exit strategy.
From breaking down the definition and formulas of EBITDA, to outlining why it is an important term in the process of valuing and selling a business, this comprehensive guide will demonstrate what EBITDA is and what it means for your company.
In its simplest definition, EBITDA is a measure of a company’s financial performance, acting as an alternative to other metrics like revenue, earnings or net income.
EBITDA is how many people determine business value as it places the focus on the financial outcome of operating decisions. It does this by removing the impacts of non-operating decisions made by the existing management, such as interest expenses, tax rates, or significant intangible assets.
This leaves a figure that better reflects the operating profitability of a business, one that can effectively be compared between companies by owners, buyers and investors. It is for that reason many employ EBITDA over other metrics when deciding which organization is more attractive.
The meaning of EBITDA’s acronym is broken down to the following:
E – Earnings
B – Before
I – Interest
T – Taxes
D – Depreciation
A – Amortization
Below is a more in-depth definition of the key terms in Earnings Before Interest, Taxes, Depreciation and Amortization:
The definition of LTM (Last Twelve Months) EBITDA, also known as Trailing Twelve Months (TTM), is a valuation metric that shows your earnings before interest, taxes, depreciation and amortization adjustments over the past 12 months.
By corresponding EBITDA to the previous year’s activity, business owners, analysts and prospective buyers, LTM EBITDA presents a strong example of a company’s current operational performance, rather than relying on a one-off value that could be misleading.
The prevailing difference between EBITDA and EBIT is the number of steps taken. EBIT (Earnings Before Interest and Tax) only presents an earning value without the impact of interest and tax rates. EBITDA goes further by also identifying and removing the expenses related to depreciation and amortization.
So, it is not actually a case of EBITDA vs EBIT. Both are useful to refer to when building up a picture of the value of a company, breaking down clearly business expenses and the relative impact they have on its worth.
Other variations of EBITDA worth noting are as follows:
All calculations can be incredibly useful in the process of discovering the value of a business, which is why they are regularly applied by prospective buyers and investors to compare companies. For this reason, our experienced M&A professionals use EBITDA as a key part of our clients’ preparations for exiting their business, alongside many other tools and methods.
Calculating EBITDA in your company can be done using one of two formulas, both producing the same result.
All of the information required to complete either EBITDA formula should be included on your balance sheet. However, this illustrates the importance of keeping accurate financials. A single mistake in these values will lead to an inaccurate EBITDA, which could overvalue or undervalue your company’s profitability.
Therefore, we would recommend investing in a quality accounting system or working with trusted accountants to ensure your finances are up-to-date and precise.
In order to figure out whether your EBITDA number is ‘good’ or not, you’ll need to calculate your EBITDA margin.
The formula for an EBITDA margin is as follows:
EBITDA margin = EBITDA / Total Revenue
By determining a percentage of EBITDA against your company’s overall revenue, this margin gives an indication of how much cash profit a business makes in a single year. If your business has a larger margin than another, it is likely a professional buyer will see more growth potential in yours.
For example, let’s say Company A has determined their EBITDA is $600,000, while their total revenue is $6,000,000. This results in an EBITDA margin of 10%. This is then compared to Company B, which has a larger EBITDA of $750,000, but with total revenue of $9,000,000.
This means that while Company B demonstrates higher EBITDA, it actually has a smaller margin than Company A (8% against 10%). Therefore, a prospective buyer weighing up both businesses might see more promise in A over B.
So, by using the EBITDA margin, an investor, owner or analyst can see how much operating cash is generated relative to all revenue earned, and can use this as a benchmark in deciding which is the most financially efficient.
Another demonstration of how good your EBITDA number is can be found using the EBITDA Coverage Ratio. The formula for this is:
If you apply this formula to your business and the result is 1 or greater, it indicates to prospective buyers or investors that your company is in a better position to pay off any debts, liabilities and other obligations. This is what is so useful about EBITDA – the variety of ways it can indicate an organization’s performance.
The differences between EBITDA and adjusted EBITDA are subtle, but important to know. In essence, adjusted EBITDA normalizes this value based on a company’s incomes and expenses. These can vary greatly between companies, making it difficult for analysts and buyers to accurately determine if the business is more appealing than another.
By standardizing income and cash flows, as well as eliminating any abnormalities (redundant assets, bonuses to owners, rent paid above market value, etc.), this makes it easier for people to compare multiple businesses at once, regardless of differences in industry, location and more.
Calculating adjusted EBITDA is simply using one of the standard EBITDA formulas above, but prior to this go a step further by removing the cost of the various one-time, irregular and non-recurring expenses that don’t have a bearing on the day-to-day running of your company.
Here is a concise list of the common balance sheet features excluded when applying adjusted EBITDA:
How to calculate and apply EBITDA is important for business owners for two key reasons:
As discussed earlier, EBITDA helps you analyze and compare profitability between companies and industries, as it eliminates the effects of financing, government or accounting decisions. This provides a rawer, clearer indication of your earnings.
Above all else, EBITDA’s importance is now as the standout formula and language applied by professional buyers, private equity investors and more when discussing business value. It is often used as a proxy for cash flow, and can help provide an estimated valuation range for your company overall by using the EBITDA multiple.
To work out the EBITDA multiple, you first need to know your Enterprise Value (EV). This is calculated by finding the sum of the following in your organization:
And then minus your cash and cash equivalents (bank accounts, marketable securities, treasury bills, etc.). Then, use this formula:
EBITDA Multiple = Enterprise Value / EBITDA
The EV/EBITDA multiple ratio indicates to analysts, M&A professionals and financial advisors whether your company is either overvalued or undervalued – if your ratio is high, it means your company might be overvalued, while a low ratio indicates it’s undervalued. The benefit to the EBITDA multiple is that it takes company debt into account, which other multiples like the Price-to-Earnings ratio doesn’t consider.
When preparing to market and communicate with buyers as part of your exit strategy, you want to speak to them in their terms and present financials they’ll be familiar with. Therefore, using an EBITDA formula and presenting the results in your documentation is crucial to give buyers insight into your company’s potential.
In short, EBITDA means you’re giving today’s buyers what they’re looking for.
While EBITDA is defined as an indication of a company’s ability to make a consistent profit, net income outlines a company’s total earnings. This difference means net income is preferably used to determine the value of earnings per share of a business, rather than its overall earning potential, which is where EBITDA proves useful.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
Net Income = Revenue – Business Expenses
Operating income is a company’s profit after subtracting operating expenses, such as depreciation and amortization. EBITDA goes the step further of stripping these out entirely to develop a firm understanding of a company’s profitability.
Nevertheless, both are useful calculations to apply when valuing a business, as operating income is effective at analyzing the production efficiency of a company’s core operations and expense management.
When presenting your company’s EBITDA and other financials for the purpose of exiting the business, you should aim to present data stretching back 3-5 years. This volume of information demonstrates the development of your business over time, reassuring buyers that your growth potential is consistent, and you haven’t just had one remarkable year.
The extent of these projections is why we strongly counsel our clients to work with us and financial experts to present values that are realistic, dependable and defendable. The more accurate these are, the lower the risk associated with your company from prospective buyers and investors.
Of course, after you’ve determined your company’s EBITDA, you’ll likely aim to increase this value before placing it on the market. Fortunately, this can be achieved through recasting your financials.
Recasting is defined as the amending and re-releasing of previously released earning statements with a specified intent. In practice, this is where an expert will cast a keen eye on your financials to reinsert any one-off earnings or expenses.
This reexamination paints a more accurate and promising picture for potential buyers of your company’s worth and potential. Do not confuse it for manipulating your statements – due diligence will uncover any inconsistencies, so this is not an opportunity to hide the facts.
Many aspects that can be recast to increase the EBITDA of your company and present a more accurate picture of its value. These include:
These five areas are just a selection of the key areas you might seek to normalize EBITDA and ensure it is maximized and represents a fair reflection of your business valuation.
As a widely-used business valuation metric, EBITDA presents significant benefits for owners, analysts and acquirers in presenting a fair reflection of a company’s value. However, it is also important to note that it is a metric that can be exploited, leading to negative consequences down the road.
While arguably EBITDA’s greatest strength is the firm focus it places on baseline profitability by excluding capital expenditure, some have viewed this as a potential weakness.
This is because, by ignoring expenditure, it can allow companies to subvert any problem areas in their financial statements. Due to the nature of the formula and the information it discounts, it can overshadow some risks in a company’s performance.
As such, EBITDA does not fall under Generally Accepted Accounting Principles (GAAP), which means companies can interpret the formula and its components in different ways. This flexibility can help them hide red flags that prospective buyers could later pick up during due diligence.
Therefore, it is recommended that you work with trusted financial advisors and M&A specialists to ensure you do not overreach in pursuit of the largest EBITDA number possible. This way, you have a clearer idea what values can be eliminated from the equation, ensuring nothing causes problems at the due diligence stage, which could result in a breakdown of trust and a loss of time and money.
The Debt to EBITDA ratio is calculated by dividing a company’s liabilities by its EBITDA value. It measures a company’s ability to pay off its debts adequately. The lower the ratio, the more likely a business will be able to pay any obligations when they are due, while a higher value means it could be difficult to clear their debts, acting as a warning sign for buyers.
The EBITDA to sales ratio is used by analysts and buyers to determine a company’s profitability by comparing its revenue to its earnings. This is calculated by dividing EBITDA by a company’s sales. It is useful in comparing similar-sized businesses where the underlying variables of their cost structures are unknown.
Similar to the Debt to EBITDA ratio, the EBITDA to fixed charges ratio identifies a company’s ability to pay off its fixed charges and similar debts, usually determined over a four-quarter trailing period.
The net profit margin is one of the most crucial indicators of a company’s financial health, calculated through the following formula:
Net Profit Margin = (Revenue – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Taxes) / Revenue x 100
This gives an indication of how much profit each dollar of sales generates. EBITDA differs from this by accounting for all expenses generated by production and daily operations but adding back costs of depreciation and amortization.
Free Cash Flow and EBITDA are two ways of assessing the value and profitability of a business. While EBITDA demonstrates a company’s earning potential after removing essential expenses like interest, tax, depreciation and amortization, free cash flow is unencumbered. It instead takes a firm’s earnings and adjusts it by adding in depreciation and amortization, then reducing working capital changes and expenditures.
Both techniques should be utilized among the many used to determine business value.
EBITDA does not fall under a Generally Accepted Accounting Principle (GAAP) as a measure of financial performance. This means that its calculation can vary from one company to another as there is no standardized approach to EBITDA.
Hopefully this in-depth guide has given you a clearer idea of how to define EBITDA, how it’s applied to business valuations, the meaning of its use and its benefits and drawbacks.
A good understanding of EBITDA is crucial if you are considering selling your business. This is the formula many analysts, buyers and investors will employ to determine the potential and value of your company, so it’s important your documentation highlights this. It will mean you’re speaking their language.
If you’d like to learn more about the what, how and why of EBITDA and other key aspects of valuing and selling a business, you can join us at our complimentary executive conference.
Held throughout North America, these conferences educate thousands of business owners about how and when to exit your business for the maximum value. By breaking down the process, defining key terms and outlining common mistakes to avoid, our conference is the essential starting point for the optimal sale of your company.
Alternatively, you can contact our team directly for M&A advice and guidance. Call us on 972-232-1121 or send us a message for more information.
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